SEC Unites Opponents on Money Fund Rule With Floating-Share Plan

June 6 (Bloomberg) -- U.S. regulators are moving forward
with proposed rules for money-market mutual funds that both
supporters and opponents say won’t do enough to address risks in
the $2.9 trillion industry.

The U.S. Securities and Exchange Commission’s proposal
approved yesterday could require funds that cater to
institutional investors to abandon the very feature that makes
them appear riskless -- their fixed share price.

In response to pushback from the funds, the proposal also
included an industry-favored alternate, so-called redemption
“gates” that would limit the ability of investors to pull out
of a fund that comes under stress. The commission left open the
option of adopting either approach or both together.

Commissioner Elisse B. Walter, who as chairman earlier this
year worked to break a commission deadlock on the issue, said
the SEC could require both a floating share value and the use of
gating.

“Each serves a purpose to mitigate systemic risks to
financial companies and markets and to protect investors, and
each does so in different ways,” Walter said after the
commission voted unanimously to move forward on the proposal.

Critics expressed doubt that the SEC plan would achieve its
goal: discouraging large investors from withdrawing their money
when funds face losses that would cause them to pull back
lending to banks and other borrowers. The commission has opened
a 90-day comment period for them to make their case.

Redeem ‘Sooner’

“When investors see signs of stress, they will have an
incentive to redeem sooner rather than later,” said Republican
Commissioner Troy A. Paredes. “Even investors that are
accustomed to seeing a fund’s net asset value fluctuate may
redeem if they expect the fund’s price to fall.”

The plan is a compromise designed to break the impasse that
stymied action last year. The five-member commission, now led by
Mary Jo White, coalesced around a floating-share price for just
the riskiest funds, those that invest in short-term corporate
debt. Funds that invest only in U.S. government securities and
ones that serve retail investors are exempt from the proposals.

The SEC’s failure to achieve consensus last year prompted
former Chairman Mary Schapiro to call on the Financial Stability
Oversight Council, an umbrella group of regulators that includes
the Federal Reserve, to recommend reforms to the SEC. The FSOC
has the authority to declare funds systemically risky if it
considers the SEC’s rules insufficient.

FSOC Proposal

The FSOC’s recommendations called for imposing tougher
rules on all money funds. One option under FSOC’s approach would
have allowed funds to keep a fixed share price if they held
capital equal to 1 percent of assets and imposed first losses on
large shareholders who recently redeemed shares.

Other experts who favor costlier regulation of money funds,
including requiring them to hold a capital cushion as banks do,
questioned whether a floating-share price would limit runs. In
2008, the $62.5 billion Reserve Primary Fund collapsed after it
“broke the buck” and money funds temporarily required a U.S.
government guarantee.

These same critics say the SEC’s alternative to requiring
prime funds to float their share values could worsen the
probability that savvy investors abandon the funds. The proposal
would allow funds to keep their fixed share value if they impose
“gates” that would suspend redemptions when their most liquid
assets fall below a certain threshold.

Floating the share value “is a zero, it’s just not going
to change anything relative to the status quo,” said Adi
Sunderam, an assistant professor of finance at Harvard Business
School. “Gating is potentially harmful in the sense that if you
get investors antsy about when the gates are going to come down,
that increases the likelihood they are going to run.”

Sunderam and colleagues have called for imposing capital
requirements along the lines recommended by FSOC.

30-day ‘Gate’

Critics of floating the share price disagree on
alternatives. Paredes said he believes gates are the best
solution to reduce systemic risk. Under the proposal, fund
companies could use the gates for as long as 30 days without
having to liquidate the fund.

“Boards have discretion over whether a fee or gate will be
instituted,” Paredes said. “Because fund investors do not know
what the board will decide, they may find it difficult to redeem
preemptively with any confidence that their timing is correct.”

The mutual-fund industry, which has lobbied against
costlier regulation, also says requiring funds to float their
share price won’t reduce the risk of runs. The Investment
Company Institute says European money funds that float their
share prices have faced large investor outflows during periods
of crisis.

Stopping Redemptions

The ICI says gates are the only tool available to stop runs
on a fund that can spread to other funds and ripple across the
financial system. Requiring investors to pay a fee once the
gates drop “aligns perfectly with the goal of stopping large,
unsustainable redemptions,” the ICI said in a commentary on
regulatory options last year.

“We are particularly pleased that the commission
recognized the effectiveness of liquidity fees and gates in
addressing risks that might arise in a widespread crisis,” ICI
chief executive officer Paul Schott Stevens said in a statement.

Fund boards would have the option to impose a 2 percent fee
on investors who sought to withdraw money after the gates went
down. The board could decide to impose a lower fee or none at
all, under the SEC’s plan.

Michael S. Barr, a top Treasury Department official from
2009 to 2010, said the SEC’s proposal isn’t the best solution
but could help improve financial stability. Barr, who helped
oversee the Treasury Department’s response to the financial
crisis, said the SEC and the FSOC may need to consider further
reforms including capital requirements.

Second-Best Reform

“This is clearly a second-best or third-best alternative
to that basic set of reforms that in a better world the SEC
would take,” Barr said.

Jeffrey N. Gordon, a professor at Columbia Law School, said
the commission’s proposal fails to make the system safer, and
might even enhance risk because institutional investors might
try to time their withdrawals to just before gates are imposed.

“The FSOC should not back down,” Gordon said. “The
proposals are lacking and the FSOC should make its own if it
thinks it has better ones.”